In 1975, Microsoft had three employees, $16,000 in revenue and a single software product–

aversion of the BASIC computer language that ran the first personal computer, the Altair 8800.

In 2000, as we mark our 25th year, Microsoft is the world’s largest software company, withnearly 40,000 employees, $23 billion in revenue, and a wide range of powerful software andInternet products, including the most popular PC operating system, productivity software andInternet network.

It’s been

truly amazing to be at the focal point of two revolutions that have swept the worldsince Microsoft’s modest beginnings: a PC revolution that has made powerful and affordablecomputing available to hundreds of millions of people around the globe, and an Internet revolutionthat is fundamentally changing how people communicate, learn and share information, and theway entire industries operate.

At the core of these remarkable advances is software–

the magic that makes this technologyuseful. At Microsoft,

software is our passion, the reason we’re excited to come to work everymorning. As we look to the future, our commitment to advance the frontiers of softwaretechnology offers extraordinary opportunities for consumers, businesses and our company.

With the release of Windows®

2000, the continuing strength of Microsoft®

Office, ourexpanding enterprise server family and the surging popularity of MSN®, we have strong corebusinesses. At the same time, we are making significant strategic investments for thefuture inkey growth areas, including wireless technologies, digital devices, games, TV, small businessand, most important, the new Microsoft .NET platform. Over the next year, we will invest morethan $4 billion in research and development to advance our

core businesses, build on ourstrategic investments and deliver on the promise of our most important software initiative ever–

Microsoft .NET.

Microsoft .NET

Just as our development of PC operating systems and other software technologies have drivengrowth in the industry over the past quarter century, today we are working to enable a new era ofempowerment for computer users, and growth opportunities for both businesses and softwaredevelopers. Microsoft .NET comprises the software and services thatwill power the NextGeneration Internet.

As anyone who has used a PC knows, today’s Internet experience can be fun, exciting andinformative. It also can be confusing and difficult. For example, Web browsing, content authoringand editing, e-mail, calendaring and contacts each require separate applications that have widelyvarying functionality and compatibility. Communicating between devices such as PCs, mobilephones and handheld devices is challenging at best. Meanwhile, information on the Internetcontinues to exist on “digital islands” of independent Web sites. This information is easy tobrowse, but difficult to edit or manipulate in any useful way. There is enormous benefit andopportunity in linking these isolated islands of data, services anddevices in ways that will enablepeople and businesses to communicate and collaborate more easily. This is where Microsoft.NET comes into play, enabling easier, more personalized and more productive Internetexperiences by harnessing constellations of smart devices and Web sites with advanced softwarebased on open Internet standards and protocols, including XML. In addition, Microsoft .NET willoffer computer users a unified interface that adapts to whatever they are doing, wherever theyare, and is device-independent–

a kind of “universal canvas” for the Digital Age.

Microsoft .NET will create immense opportunity for hundreds of thousands of developers andindustry partners, by providing the tools to build a new generation of truly distributed Webmsf t

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services that will transform the Internet and every other aspect of computing. Microsoft .NET willrevolutionize computing and communications in the first decade of the 21st century, by being thefirst platform that takes full advantage of both. Microsoft .NET will take several years to come tofull fruition, but we are tremendously excited about the potential.

The Foundations of Microsoft .NET

Microsoft .NET will build extensively on Microsoft’s current core businesses, including theWindows family of desktop and server operating systems, enterprise server applications,Microsoft Office and MSN, each of which is performing strongly today. Windows 2000 has metwith strong customer adoption and highly favorable reviews among IT managers, office users andindustry analysts, making it the most powerful business operating system ever released byMicrosoft. Underscoring its reliability and the value of its new features, General Motors, RoyalDutch/Shell, Xerox Corp., and leading PC manufacturers–

Windows Me, the latest version of the Windows operating system designed specifically forhome users, released in September, provides consumers with an improved user and Internetexperience, enhanced home-based networking features and compelling new digital media tools.

Today, Windows 2000 servers are powering the World Wide Web. A majority of the topInternet retail sites, business-to-business Web sites and secure Web sites are running onWindows 2000 Server or Windows 2000 Advanced Server, and more Fortune 500 sites arerunning on Windows 2000 technology than any other technology. Windows 2000 DatacenterServer, launched in September 2000, will provide even more power and reliability for high-trafficnetworks.

If Windows 2000 is the foundation of Microsoft’s .NET strategy, our .NET Enterprise Serverproducts are the cornerstones. In the year ahead we are launching seven new and updatedenterprise server products. Microsoft’s range of server applications, combined with the powerand reliability of Windows 2000, offer versatility and affordability unrivaled by any of ourcompetitors. They also represent significant new opportunitiesto enhance Microsoft’s revenuestream.

Microsoft Office revenue was strong as major enterprise accounts continued to adopt theworld’s most popular productivity suite. The growing deployment of Windows 2000 on thedesktop is expected to further stimulatesales of Office 2000. New technologies that integrateWeb services directly into the Office user experience, as well as tools that enable users to moreefficiently store, access and analyze crucial business information, are being developed for futureversions of Microsoft Office. Office.NET will offer a powerful productivity and communicationsservice designed to meet the needs of 21st century knowledge workers. Use of Microsoft’sVisio®

and Microsoft Project applications is also continuing to grow and empower knowledgeworkers in important new ways.

Fiscal year 2000 was a defining year for MSN. In June, the MSN network of Internet servicesbecame the #1 worldwide Internet destination for consumers. In the United States, MSN grewsignificantly faster than Yahoo! or AOL. With MSN services available in 33 international marketsand 17 languages, it is the #1 site among consumers in many countries around the world. OurMSN Internet Access business grew by more than 50 percent. Key to this remarkable growth isMSN best-of-breed services, including MSN Hotmail®, the world’s largest e-mail system withmore than 67 million active accounts; MSN Messenger Service, our instant messaging servicewith more than 18 million users; MSN Search, the second most popularsearch service on theWeb; and MSN eShop, which experienced a significant increase in holiday traffic last year.

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Investments in Tomorrow

One of the keys to Microsoft’s success over our first 25 years is the long-term view we have takentoward the development of technologies such as Windows, Office, MSN and other products. Inthe coming year, we will continue to focus on promising new technological advances in a numberof key fields.

Television

Digital and enhanced television products and services represent a significant growth opportunityfor Microsoft and one that will give consumers more choice and control over when and what theywatch, richer participation with TV programming, and convenient access to the Internet and familyand friends. Microsoftis investing in three areas:

—>

Working with television service operators–

including AT&T in the United States, UPC inEurope, Rogers in Canada, and Towngas/iCare in Hong Kong–

to deploy enhanced TV tomore than 15 million subscribers via the Microsoftplatform;

—>

Joining with DIRECTV, Thomson, and Sony to produce UltimateTV, a one-box, one-serviceenhanced TV solution that will include two digital tuners to enable background recording, anda 40-gigabyte hard drive capable of recording 35 hours of TV programming.

—>

Continuing to grow the WebTV®

service, which now has more than 1 million subscribers whocan participate in new ways with their favorite TV shows, vote in live polls, receive up-to-the-minute news coverage, and send and receive e-mail using their TV set at home.

Games

In the last few years, Microsoft has emerged as one of the top PC games publishers in the UnitedStates. In calendar 1999, Microsoft had two of the top five best sellers: Flight Simulator and Ageof Empires®. During the 1999 holiday season, we were the only games publisher with three titleson the Top 10 list. Building on this success,Microsoft is investing significant resources todevelop Xbox™, which will compete with the Sony PlayStation and game consoles by Sega andNintendo in a multi-billion-dollar industry. The hardware design for Xbox is already complete, andMicrosoft has 30 game titles for it under development in-house, with more in the works by third-party developers. The fall 2001 launch of Xbox will be Microsoft’s biggest ever–

larger even thanWindows 95.

Wireless

Microsoft will invest substantially in the coming year to enable truly intelligent communicationsthat fluidly traverse the boundaries of work, individual and family time, while offering ways tocontrol the tremendous volume of available information. Alliances are key to our wirelessstrategy. For example, we

are working with AT&T and British Telecommunications on mobileapplications for next-generation data networks; with NTT DoCoMo of Tokyo to develop wirelessportals; and with Ericsson to create end-to-end solutions and services for the wireless Internet.

One of the biggest opportunities is working with network operators and carriers to empowertheir service platforms with Microsoft’s existing and emerging technologies. The building blocksof .NET will further enhance the types of services we will be able to provide. Microsoft isdeveloping platforms and applications for a variety of mobile handheld devices, includingcellular/mobile phones, Pocket PCs and smart phones. These devices will offer both voice andrich data capabilities, including true HTML Web

browsing on color displays. Our research insmart cards, location-based services, and speech technologies will also have importantapplications in the wireless arena.

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Small Business

A great opportunity exists for Microsoft to help small businesses increase productivity and takeadvantage of the Internet to connect in new ways with customers, industry partners, andsuppliers. Today, small businesses represent nearly 60 percent of the global economy. Yet theirinvestments in software are far smaller per

desktop than larger enterprises, even as they arebeing increasingly impacted by the digital economy.

The emergence of the Internet and .NET services will make technology more accessible andrelevant to small businesses than ever before. By providing complete business solutions thatinclude productivity, customer management and collaboration software, as well as technologies topower the specific needs of small-business operations and e-commerce, Microsoft can enablesmall businesses to better use technology to their business advantage. Over the next four years,technology spending by small businesses is forecast to increase by more than $50 billion. Withmore than 1 million registered users, bCentral™, Microsoft’s Web-based small-business portal isalready #1 in terms of reach. Over the next year, bCentral will deliver a number of new Webservices, as well as launch in five additional countries. We will also be launching a new versionof the leading small-business server suite, Small Business Server 2000.

Building the Future Together

In partnership with thousands of other technology companies that share our vision of high-performance, affordable computing, Microsoft has helped build a high-tech industry that is thrivingon innovation and competition,and driving growth in the U.S. economy. That is one of thereasons why we believe the appellate courts will rule in Microsoft’s favor in the antitrust lawsuitand uphold the well-established legal precedent that U.S. antitrust law should encourage, notdiscourage, firms to improve their products rapidly to meet customer needs. We also believe theappellate courts will recognize that the district court’s order to break up Microsoft and imposecrippling regulations reached far beyond the facts of the case,and would lead to less innovation,fewer choices and higher prices.

Finally, on the occasion of Microsoft’s 25th anniversary, we would like to take a moment toacknowledge the passionate, smart, dedicated employees who have helped make Microsoft theglobal

leader in software, as well as our millions of shareholders, thousands of business partners,and hundreds of millions of customers around the world who have enabled the company tosucceed over the years. The future is filled with amazing possibilities and opportunities, and ourpassion for improving people’s lives through great software will allow us to contribute even morethan in our first 25 years.

Bill Gates

Chairman and Chief Software Architect

Steven A. Ballmer

President and Chief Executive Officer

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A wide range of .NET experiences will open the door to significant new benefits for consumersand business users, as well as revenue opportunities for Microsoft. These include:

Windows.NET

The next generation of Windows will be designed to put users in control of their digital informationthrough customized applications and services created by Microsoft and a wide range of third-party providers.

MSN.NET

Will enable consumers to create a single digital identity, and use smart services to ensureconsistent, seamless and safe access to information, entertainment and people any time, anyplace and on any device.

Subscription Services

Building on the depth of our experience creating software for personal use, these subscriptionservices will offer many of the benefits of today’s desktop applications with the flexibility,integration and “roaming” support of the new .NET family of user experiences.

Office.NET

Will include a new natural user interface, a new architecture based on smart clients, and servicesto provide rich functionality and performance and universal collaboration services.

bCentral.NET

Our small-business Web services will be built on .NET infrastructure and be greatly expanded todeliver commerce and collaboration solutions as well as business automation services such ascustomer lead-tracking.

Visual Studio.NET

An XML-based programming model and rapid application development tool that will enable theeasy delivery of highly distributed programmable services running across stand-alone machines,corporate data centers and the Internet.

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Microsoft’s lineup of new enterprise server products includes:

Microsoft SQL Server™ 2000

The newest version of Microsoft’s database and analysis server enables customers to rapidlybuild scalable e-commerce, line-of-business and data warehousing solutions. SQL Server 2000is fully Web-enabled, with end-to-end support for XML and a new, integrated data-mining engine.

Microsoft Exchange 2000 Server

The latest version of Microsoft’s messaging and collaboration server, designed to meet the needsof businesses of all sizes, provides a single infrastructure and user model for working withmessages, documents and applications to increase knowledge worker productivity.

simplifying the tasks involved in software scaling, adding new servers, and deploying andmanaging distributed applications. With software scaling there is no single point of failure, andcapacity can be added economically and as needed.

Host Integration Server 2000

The follow-on release to SNA Server extends Windows to other systems by providing application,data, and network integration that enables businesses to preserve their investments in existingmainframe, AS/400 and Unix networks, applicationsand databases.

Commerce Server 2000

Commerce Server 2000 provides the infrastructure that enables organizations to build aneffective online business. User profiling and management, product and service management,transaction processing, and targeted marketing and merchandising are all integrated to create acomprehensive, customizable system.

“Microsoft .NET really brings to the Web what we’ve been missing, and that’s the ability to drivegreater consistency and simplicity. Compaq’s full range of products and services, coupled withour longstanding relationship with Microsoft, puts us in a unique position to take .NET to market.”

Michael D. Capellas, President and CEO, Compaq Computer Corp.

“Microsoft’s vision for Microsoft .NET is a whole new level of capability, interaction andcustomization in the user experience–

it will really leverage the power of the Internet.”

Michael Dell, CEO, Dell Computer Corp.

“When Qwest looks at leveraging Microsoft .NET, what we have in our minds eye is to change theway people access software, not just from where they are but from the devices they use, from theease of use, from the ability to write applications in a more efficient way and distribute them moreefficiently. I think that has a profound effect on how software is used

as an enabling technology.Qwest sees itself helping its clients change the way they do business by helping them understandthe power of this new technology.”

Joseph P. Nacchio, Chairman and CEO, Qwest

“Verio shares Microsoft’s vision of .NET, thatbusinesses want to have a complete package thatallows them to integrate applications, share data and compete effectively in this new onlineeconomy. First, we’ll roll out the Microsoft .NET Passport service. This will allow us to helpattract consumersand customers to our business Web sites. In the future, we see a lot ofexcitement in the collaboration tools, messaging services and commerce services that Microsoftplans to bring to the fold.”

Justin Jaschke, CEO, Verio Inc.

“Andersen Consulting is really excited about Microsoft .NET because this is a big win for ourclients. It lets our clients leverage their IT investments. It lets them move to the Web-enabledworld. It lets them simplify systems integration so that they can concentrate on what they dobest, and that is changing their business to compete in the new economy.”

have been a si gni fi cant factor i n the Company’s revenue growth. The average sel li ng pri ce per l i cense hasdecreased, pri mari ly because of general shi fts i n the sal es mi x from retai l packaged products to l i censi ng programs, from new

products to product upgrades, and from stand-al one desktop appl i cati ons to i ntegrated product sui tes. Average revenue perl i cense from OEM l i censes and organizational l icense programs i s l ower than average revenue per l i cense from retai l versi ons.

The Company’s busi ness model continues to evol ve from retailing packaged products to l i censi ng organi zati onal l i censesand subscri pti ons. The Company’s products are general ly deli vered to end users through a mul ti-ti ered channel of di stri butorsand resel l ers, but the di stri buti on model i s al so changi ng for sel ected retai l products that are now bei ng shi pped strai ght toresel l ers and other sel ected products that are now being shi pped strai ght to end users. Due to these changes i n channelmechani cs and the busi ness model, the ri sk of returns of product from di stri butors and resel l ers has decl i ned. Accordi ngl y,theesti mate for future product returns was reduced by $250 mi l li on i n the fourth quarter of fi scal 1999.

requi res compani es to use the average sal espri ce of each undel i vered el ement of software arrangements to unbundl e revenue. Pri or authori tative gui dance al l owed acompari son of the total pri ce differential between a l i censed product sol d through di fferent channel s of di stri buti on to derive theval ue of undeli vered elements offered to customers acqui ring product from one channel but not the other. Upon adopti on of thi snew rul e i n the fourth quarter of fi scal 1999, the percentages of the total arrangement treated as unearned decreased. Thi schange reduced the amount of Microsoft Wi ndows and Mi crosoft Offi ce sal es treated as unearned and i ncreased the amount ofrevenue recogni zed upon shi pment. Addi ti onal ly, as part of the Company’s l ong range planning process and a revi ew of product

shi pment cycl es, i t was determi ned that the l i fe cycl e of Wi ndows shoul d be extended from two years to three years.

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Business Divisions

Mi crosoft has three maj or segments: Productivity Applicati ons and Devel oper; Wi ndowsPl atforms; and Consumer and Other.

support, and admi nistrati ve staff. Commitments for constructi ng new bui ldings were $299 mi l l i on on June 30, 2000.Cash wi l l al so be used to fund ventures and other strategi c opportuni ti es.

i s effecti ve forthe Company as of Jul y 1, 2000. SFAS 133 requi res that an entity recognize all derivati ves as ei ther assets or l i abi l ities measuredat fai rval ue. The accounting for changes i n the fair val ue of a deri vati ve depends on the use of the deri vati ve. Adopti on of these

new accounti ng standards wi l l resul t i n cumulative after-tax reducti ons i n net i ncome of approxi matel y $350 mi l l i on and othercomprehensi ve i ncome of approxi mately $50 milli on i n the fi rst quarter of fi scal 2001. The adopti on wi l l al so i mpact assets andl i abi l i ti es recorded on the bal ance sheet.

i n December 1999. The SAB summarizes certai n of the SEC staff’s vi ews i n appl yi ng general l y acceptedaccounti ng pri nciples to revenue recognition i n fi nancial statements. In June 2000, the SEC i ssued SAB 101B, whi ch del ays thei mpl ementati on date of SAB 101 until no l ater than the fourth fi scal quarter of fi scal years begi nni ng after December 15, 1999.The Company does not bel i eve that adopti on of thi s SAB wi l l have a materi al i mpact on i ts fi nanci al statements.

whi ch cl ari fi es the appl i cati on of APB 25 for certai n i ssues. The i nterpretati on i seffecti ve Jul y 1, 2000, except for the provi si ons that rel ate to modifications that di rectly or i ndi rectly reduce the exerci se

pri ce of anaward and the defi nition of an empl oyee, whi ch are effecti ve after December 15, 1998. The Company does not bel i eve thatadopti on of FIN 44 wi l l have a materi al i mpact on i ts fi nanci al statements.

i s anti ci pated that these i nvestments i n research and devel opment wi l l i ncrease over hi stori cal spendi ng l evel s wi thoutcorrespondi ng growth i n revenue i n the near future. Si gnificant revenue from these product opportunities may not be achieved

fora number of years, i f at al l.

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PC Growth Rates

The nature of the PC marketpl acei s changing i n ways that may reduce Mi crosoft’s software sal es and revenue growth. Recently,manufacturers have sought to reach more consumers by devel oping and producing l ower cost PCs–

PCs that come wi thout pre-i nstal l ed software or contain software with reduced functional ity. In addition to the i nfl ux of l ow-cost PCs, a market for handhel dcomputi ng and communicati on devices has devel oped. Whi le these devi ces are not as powerful or versati l e as PCs, they threatento erode sal es growth i n the market for PCs wi th pre-i nstal l ed software. Thi s may affect Mi crosoft’s revenue growth becausemanufacturers may choose not to i nstal l Mi crosoft software i n these l ow-cost PCs or consumers may purchase al ternati vei ntel l igent devices that do not uti l i ze Mi crosoft

software. These l ower-pri ced devi ces requi re Mi crosoft to provi de l ower-pri cedsoftware wi th a subset of the ori gi nal functi onali ty. As a resul t, the Company may generate l ess revenue from the sal e of softwareproduced for these devi ces than from the sal e of software for PCs.

An i ncreasi ngl y higher percentage of the Company’s revenue i s subj ect to ratable recognition, whi ch i mpacts the ti ming of revenueand earni ngs recognition. This pol icymay be required for additional products, dependi ng on speci fic l icense terms and condi ti ons.Al so, mai ntenance and new subscri pti on programs such as the appl i cati on servi ce provi der (ASP) model are i ncreasi ng i npopul ari ty.

Employee Compensation

Mi crosoft empl oyees currentl y recei ve sal ari es, i ncenti ve bonuses, other benefi ts, and stock opti ons. New governmentregul ati ons, poor stock pri ce performance, or other factors coul d di mi ni sh the val ue of the opti on program to current andprospecti ve empl oyees and force the Company i nto more of a cash compensati on model.

International Operations

Mi crosoft devel ops and sel l s products throughout the worl d. The pri ces of the Company’s products i n countri es outsi de of the

Uni ted States are generall y higher than theCompany’s pri ces i n the Uni ted States because of the costs i ncurred i n l ocal i zi ngsoftware for non-U.S. markets. The costs of produci ng and sel l i ng the Company’s products i n these countri es are al so hi gher.Pressure to gl obal ize Mi crosoft’s pri ci ng structure mi ght require that the Company reduce the sal es pri ce of i ts software i n othercountri es, even though the costs of the software conti nue to be hi gher than i n the Uni ted States. Negati ve changes i n software“pi racy” trade protecti on l aws, pol i ci es and

The Company uses a val ue-at-ri sk (VAR) model to esti mate and quanti fy i ts market ri sks. The VAR model i s not i ntended torepresent actual l osses i n fai r val ue, but i s used as a ri sk esti mati on and managementtool. Assumpti ons appl i ed to the VARmodel at June 30, 1999 and 2000 i nclude the fol lowi ng: normal market conditions; Monte Carl o model i ng wi th 10,000 si mul atedmarket pri ce paths; a 97.5% confi dence i nterval; and a 20-day esti mated l oss i n fai r val ue for

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Accordi ngl y, 97.5% of the ti me the esti mated 20-day l oss i n fai r val ue woul d be nomi nal for forei gn currency denomi natedi nvestments and accounts recei vable at June 30, 1999 and 2000, and would not exceed $95 mi llion and $211 mill i on at June 30,1999 and 2000 for i nterest-sensi ti ve i nvestments or $1.38 bi l lion or $1.02 bill ion at June 30, 1999 and 2000 for equi ty securi ti es.

Li ti gation regarding i ntellectual property ri ghts, patents, and copyri ghts occurs i n the PC software i ndustry. In addi ti on,there aregovernment regulation and i nvesti gation ri sks al ong wi th other general corporate l egal ri sks. The Company i s a defendant i n al awsui t fi l ed by the Antitrust Di vi si on of the U.S. Department of Justi ce and a group of ni neteen state Attorneys General al legi ngvi ol ati ons of the Sherman Act and vari ous state anti trust l aws. After the tri al, the Di stri ct Court entered Fi ndi ngs of Fact andConcl usi ons of Law stati ng that Mi crosoft had vi olated secti ons of the Sherman Act and vari ous state anti trust l aws. A Judgmentwas entered on June 7, 2000 ordering, among other thi ngs, the breakup of Mi crosoft i nto two companies. On June 20, 2000, theDi stri ct Court entered an order stayi ng the Judgment of June 7, 2000 i n i ts enti rety unti l the appeal therefrom i s heard anddeci ded, unless the stay i s earl i er vacated by an appellate court.Al though Mi crosoft bel ieves i t wi l l obtain ultimate rel i ef from theJudgment, the Company cannot predict wi th certainty when or the extent to whi ch such rel i ef wi ll be obtained. The fai lure toobtainrel i ef from certai n provi si ons of the Judgment through the appeal would l ikel y have a material adverse effect on the Company. Al arge number of anti trust cl ass acti on l awsui ts have been i ni ti ated agai nst Mi crosoft. These cases al l ege that Mi crosoft has

The revenue growth rate i n 2001 may not approach the l evel attained i n pri or years. As di scussed previ ousl y, certai n operatingexpenses are expected to i ncrease i n 2001. Because of the fi xed nature of a si gni ficant porti on of operati ng expenses, coupl edwi th the possi bi l i ty of sl ower revenue growth, operati ng margi ns i n 2001 may decrease from those i n 2000.

l i cense programs i s recorded when the software has been del i vered and the customer i s i nvoi ced. Revenue from packagedproduct sal es to and through di stri butors and resel l ers i s recorded when rel ated products are shi pped. Mai ntenance andsubscri pti on revenue i s recogni zed ratably over the contract peri od. Revenue attri butabl e to undel i vered el ements, i ncl udi ngtechni cal support and Internet browser technol ogi es, i s based on the average sal es pri ce of those el ements and i s recogni zedratabl y on a strai ght-l i ne basi s over the product’s l i fe cycl e. When the revenue recogni ti on cri teri a requi red for di stri butor andresel l er arrangements are not met, revenue i s recogni zed as payments are recei ved. Costs rel ated to i nsi gni fi cant obl i gati ons,whi ch i ncl ude tel ephone support for certai n products, are accrued. Provi si ons are recorded for returns, concessi ons and baddebts.

Cost of Revenue

Cost of revenue i ncl udes di rect costs to produce and di stri bute product and di rect costs to provi de onl i ne servi ces, consul ting,product support, and trai ni ng and certi fi cati on of system i ntegrators.

Research and Development

Research and devel opment costs are expensed as i ncurred. Statement of Fi nanci al Accounti ng Standards (SFAS) 86,Accounti ng for the Costs of Computer Software to Be Sol d, Leased, or Otherwi se Marketed,

Income tax expense i ncludes U.S. and i nternational i ncome taxes,pl us the provi si on for U.S. taxes on undi stri buted earni ngs ofi nternati onal subsi diari es. Certai n i tems of i ncome and expense are not reported i n tax returns and fi nanci al statements i nthesame year. The tax effect of thi s di fference i s reported as deferred i ncome taxes.

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Notes to Financial Statementsconti nued

Financial Instruments

The Company consi ders al l l iquid i nterest-earni ng i nvestments wi th a maturity of three months or l ess at the date of purchase tobe cash equi val ents. Short-term i nvestments generall y mature between three months and si x years from the purchase date. Al lcash and short-term i nvestments are cl assi fi ed as avai l able for sal e and are recorded at market usi ng the speci fi c i denti fi cati onmethod; unreal i zed gai ns and l osses are refl ected i n other comprehensi ve i ncome. Cost approxi mates market for al lcl assi fi cati ons of cash and short-term i nvestments; real i zed and unreal i zed gai ns and l osses were not materi al.

Equi ty and other i nvestments i ncl ude debt and equity i nstruments. Debt

securi ti es and publ i cl y traded equi ty securi ti es arecl assi fi ed as avai l able for sal e and are recorded at market usi ng the speci fic i dentificati on method. Unreal i zed gai ns and lossesare refl ected i n other comprehensi ve i ncome. Al l other i nvestments, excl uding j oint venture arrangements, are recorded at cost.

i s effecti ve for the Company as of Jul y 1, 2000. SFAS 133 requiresthat an enti ty recognize al l deri vatives as ei ther assets or l i abi lities measured at fai r val ue. The accounting for changes i n the fai rval ue of a deri vative depends on the use of the deri vati ve. Adoption of these new accounting standards wi l l resul t i n cumul ati veafter-tax reducti ons i n net i ncome of approxi mately $350 mil lion and other comprehensi ve i ncome of approxi mately $50 mil l i on i nthe fi rst quarter of fi scal 2001. The adopti on wi l l al so i mpact assets and l i abi l i ti es recorded on the bal ance sheet.

Property and Equipment

Property and equi pment i s stated at cost and depreci ated usi ng the strai ght-line method over the shorter of the esti mated l i fe ofthe asset or the l ease term, rangi ng from one to 15 years. As requi red by SOP 98-1,Accounting for Costs of Computer SoftwareDevel oped or Obtained for Internal Use,

Microsoft began capital izing certain computer software devel oped or obtained for i nternaluse i n fi scal 2000. Capitalized computer software i s depreci ated usi ng the strai ght-l ine method over the shorter of the esti matedl i fe of the software or

three years.

Reclassifications

As requi red by Emergi ng Issues Task Force (EITF) Issue 00-15,Cl assi fi cation i n the Statement of Cash Fl ows of the Income TaxBenefi t Recei ved by a Company upon Exerci se of a Nonqual ified Empl oyee Stock Opti on,

A porti on of Mi crosoft’s revenue i s earned ratably over the product l ife cycl e or, i n the case of subscri pti ons, over the peri od of thel i cense agreement.

End users recei ve certai n elements of the Company’s products over a peri od of ti me. These el ements i ncl ude i tems such asbrowser technol ogies and technical support. Consequently, Microsoft’s earned revenue refl ects the recognition of the fai r val ue ofthese el ements over the product’s l i fe cycl e. Upon adopti on of SOP 98-9 duri ng the

fourth quarter of fi scal 1999, the Companywas requi red to change the methodol ogy of attributing the fai r val ue to undel i vered el ements. The percentages of undel i vered

el ements i n rel ati on to the total arrangement decreased, reduci ng the amount of Wi ndows and Offi ce revenue treated asunearned, and i ncreasi ng the amount of revenue recogni zed upon shi pment. The percentage of revenue recogni zed ratabl ydecreased from a range of 20% to 35% to a range of approxi matel y 15% to 25% of Wi ndows desktop operati ngsystems. Fordesktop appl i cati ons, the percentage decreased from approximately 20% to a range of approxi matel y 10% to 20%. The rangesdepend on the terms and conditions of the l i cense and pri ces of the el ements. In addition, i n the fourth quarter of fi scal 1999, theCompany extended the l i fe cycl e of Wi ndows from two to three years based upon management’s revi ew of product shi pmentcycl es. Product l i fe cycl es are currentl y esti mated at 18 months for desktop appl i cati ons. The Company al so sel l s subscri pti onsto certai n products vi a mai ntenance and certai n organi zati onal l i cense agreements. At June 30, 1999 and 2000, Wi ndowsPl atforms products unearned revenue was $2.17 bi l l i on and $2.61 bi l l i on and unearned revenue associ ated wi th Producti vi tyAppl i cations and Devel oper products total ed $1.96 bill ion and $1.99 bi llion. Unearned revenue for other miscel l aneous programstotal ed $116 mi l l i on and $210 mi l l i on at June 30, 1999 and 2000.

enti rel y of AT&T 5% converti bl e preferred debt wi th a contractual maturi ty of 30 years. The debt i sconverti bl e i nto AT&T common stock on or after December 1, 2000, or may be redeemed by AT&T upon sati sfacti on of certai ncondi ti ons on or after June 1, 2002. Equity securi ti es that are restri cted for more than one year or not publicly traded are recordedat cost. At June 30, 1999 and 2000, the esti mated fai r val ue of these i nvestments i n excess of thei r recorded basi s was $2.3

wi th the underl yi ng equi ty securi ti es. At June 30, 1999 and 2000, the noti onal amount of theopti ons outstandi ng was $2.1 bi ll ion and $4.0 bill ion; the fai r val ue represents obl i gati ons of $1.0 bi l l i on and $1.7 bi l l i on; andpremi ums pai d for the opti onswere not materi al. Real i zed gai ns and l osses of equi ty and other i nvestments i n 1998 were notmateri al; real ized gains were $623 mi llion and $1.7 bi l l i on i n 1999 and 2000 and l osses were not materi al i n 1999 and 2000.

msf t

27

Notes to Financial Statementsconti nued (i n mi llions)

Income Taxes

The provi si on for i ncome taxes consi sted of:

Year Ended June 30

1998

1999

2000

Current taxes:

U.S. and state

$

2,518

$

4,027

$

4,744

Internati onal

526

281

535

Current taxes

3,044

4,308

5,279

Deferred taxes

(417)

(202)

(425)

Provi si on for i ncome taxes

$

2,627

$

4,106

$

4,854

U.S. and i nternati onal components of i ncome before i ncome taxes were:

Year Ended June 30

1998

1999

2000

U.S.

$

5,072

$10,649

$

11,860

Internati onal

2,045

1,242

2,415

Income before i ncome taxes

$

7,117

$11,891

$

14,275

The effecti ve i ncome tax rate i ncreased to 36.9% i n 1998 due to the nondeducti bl e wri te-off of WebTV i n-processtechnol ogi es. In 1999, the effective tax rate was 35.0%, excl uding the i mpact of the gain onthe sal e of Softi mage, Inc. In 2000,the effecti ve tax rate was 34.0%, and i ncluded the effect of a 2.5% reduction from the U.S. statutory rate for tax credi ts and a 1.5%i ncrease for other i tems. The components of the di fferences between the U.S. statutory tax rate and the Company’s effecti ve taxrate i n 1998 and 1999 were not si gni fi cant.

Deferred i ncome taxes as of June 30 were:

1999

2000

Deferred i ncome tax assets:

Revenue i tems

$

1,145

$

1,320

Expense i tems

648

2,122

Deferred i ncome tax assets

1,793

3,442

Deferred i ncome tax l iabi lities:

Unreal i zed gain on i nvestments

(1,046)

(874)

Internati onal earnings

(647)

(1,766)

Other

(16)

(121)

Deferred i ncome tax l iabi lities

$

(1,709)

$

(2,761)

msf t

28

Notes to Financial Statementsconti nued (i n mi llions)

The Internal Revenue Servi ce (IRS) has assessed taxes for 1990 and 1991, whi ch the Company i s contesti ng i n U.S. TaxCourt. Income taxes, except for taxes rel ated to the 1990 and 1991 assessments, have been settl ed wi th the IRS for al l yearsthrough 1994. The IRS i s exami ni ng the Company’s U.S. i ncome tax returns for 1995 and 1996. Management bel i eves anyrel ated adj ustments that mi ght be required wi l l not be material to the fi nanci al statements. Income taxes pai d were $1.1 bi ll i on i n1998, $874 mi l l i on i n 1999, and $800 mi l l i on i n 2000.

In January 2000, the Company termi nated i ts stock buyback program. Pri or to thi s termi nati on, theCompany peri odi cal l yrepurchased i ts common shares i n the open market to provi de shares for i ssuance to empl oyees under stock opti on and stockpurchase pl ans. Duri ng 1998, the Company executed two forward settl ement structured repurchase agreements wi th ani ndependent thi rd party total i ng 42 mi l l i on shares of stock and pai d cash for a porti on of the purchase pri ce. In 1999, theCompany settl ed the agreements by returni ng 28 mill i on shares of stock, based upon the stock pri ce on the date of settl ement.

The ti mi ng and method of settl ement were at the di screti on of the Company. The di fferential between the cash pai d and the pri ceof Mi crosoft common stock on the date of the agreement was ori gi nal l y refl ected i n common stock and pai d-i n capi tal.

Put Warrants

Pri or to the termi nation of the stock buyback program, Mi crosoft enhanced the program by sel l i ng put warrants to i ndependentthi rd parti es. These put warrants enti tle the hol ders to sel l shares of Mi crosoft common stock to the Company on certai n dates

atspeci fi ed pri ces. On June 30, 2000, warrants to put 157 mi l l i on shares were outstandi ng wi th stri ke pri ces rangi ng from $70to$78 per share. The put warrants expi re between September 2000 and December 2002. The outstandi ng put warrants permi t anet-share settl ement at the Company’s opti on and do not resul t i n a put warrant l i abi l i ty on the bal ance sheet.

msf t

29

Notes to Financial Statementsconti nued (i n mi llions)

Other Comprehensive Income

The changes i n the components of other comprehensi ve i ncome are

as fol l ows:

Year Ended June 30

1998

1999

2000

Net unreal i zed i nvestment gains/(l osses):

Unreal i zed holding gains, net of tax effect of $355 i n 1998,

$772 i n 1999, and $248 i n 2000

$

660

$

1,432

$

531

Recl assi fi cati on adj ustment for gai ns i ncl uded i n

net i ncome, net of tax effect of $(18) i n 1998,

$(205) i n 1999, and $(420) i n 2000

(33)

(380)

(814)

Net unreal i zed i nvestment gains/(l osses)

627

1,052

(283)

Transl ati on adj ustments and other

(124)

69

23

Other comprehensi ve i ncome/(l oss)

$

503

$

1,121

$

(260)

Employee Stock and Savings Plans

Employee Stock Purchase Plan

The Company has an empl oyee stock purchase pl an for al l el i gi bl e empl oyees. Under the pl an, shares of the Company’scommon stock may be purchased at si x-month i ntervalsat 85% of the l ower of the fair market val ue on the fi rst or the l ast day ofeach si x-month peri od. Empl oyees may purchase shares havi ng a val ue not exceeding 10% of thei r gross compensati on duri ngan offeri ng peri od. Duri ng 1998, 1999, and 2000, employees purchased 4.4 mil lion, 2.7 milli on, and 2.5 milli on shares at averagepri ces of $27.21, $52.59, and $72.38 per share. At June 30, 2000, 68.4 mi l l i on shares were reserved for future i ssuance.

Savings Plan

The Company has a savi ngs pl an, whi ch quali fi es

under Secti on 401(k) of the Internal Revenue Code. Parti ci pati ng empl oyeesmay contri bute up to 15% of their pretax sal ary, but not more than statutory l imits. The Company contri butes fi fty cents for

The Company has stock opti on plans for di rectors, offi cers, and employees, whi ch provi de for nonqual i fi ed and i ncenti ve stockopti ons. Opti ons granted pri or to 1995 generall y vest over four and one-hal f years and expi re 10 years from the date of grant.Opti ons granted duri ng and after 1995 generally vest over four and one-half years and expi re

seven years from the date of grant,whi l e certai n opti ons vest ei ther over four and one-half years or over seven and one-hal f years and expi re after 10 years. At June30, 2000, opti ons for 341 mi l l i on shares were vested and 734 mi l l i on shares were avai l abl e for future grants under the pl ans.

Basi c earni ngs per share i s computed on the basi s of the wei ghted average number of common shares outstandi ng. Di l utedearni ngs per share i s computed on the basi s of the wei ghted average number of common shares outstandi ng pl us the effect ofoutstandi ng preferred shares usi ng the “i f-converted” method, assumed net-share settl ement of common stock structuredrepurchases, and outstandi ng stock opti ons usi ng the “treasury stock” method.

The components of basi c and di l uted

earni ngs per share were as fol l ows:

Year Ended June 30

1998

1999

2000

Net i ncome

$

4,490

$

7,785

$

9,421

Preferred stock di vi dends

28

28

13

Net i ncome avai lable for common sharehol ders

$

4,462

$

7,757

$

9,408

Wei ghted average outstandi ng sharesof common stock

4,864

5,028

5,189

Di l uti ve effect of:

Common stock under structured repurchases

6

13

–

Put warrants

–

–

2

Preferred stock

34

16

7

Empl oyee stock opti ons

458

425

338

Common stock and common stock equi val ents

5,362

5,482

5,536

Earni ngs per share:

Basi c

$

0.92

$

1.54

$

1.81

Di l uted

$

0.84

$

1.42

$

1.70

Operational Transactions

In August 1997, Mi crosoft acquired WebTV Networks, Inc., an onl i ne servi ce that enabl es consumers to experi ence the Internetthrough thei r televi si ons vi a set-top termi nal s based on propri etary technol ogi es. A di rector of the Company owned 10% ofWebTV. Mi crosoft paid $425 mil lion i n stock and cash for WebTV. The Company recorded an i n-process technol ogies wri te-off of$296 mi l l i on i n the fi rst quarter of fi scal 1998.

In August 1998, the Company sol d a whol ly-owned subsi di ary, Softi mage, Inc. to Avi d Technology, Inc. and recorded a pretaxgai n of $160 mi l l i on. As part of a transi ti onal servi ce agreement, Mi crosoft agreed to make certai n development tool s andmanagement systems avai l abl e to Avi d for use i n the Softi mage busi ness.

In September 1999, the Company sol d the entertai nment ci ty gui de porti on of MSN Si dewal k to Ti cketmaster Onl i ne-Ci tySearch, Inc. (TMCS) for a combi nati on of TMCS stock and warrants wi th a val ue of $223 mi l l i on. The transacti on al soi ncl uded a di stri buti on agreement. Microsoft recognized a gai n of $156 mi llion on the sal e and wi l l recogni ze revenue amountsrel ated to the di stri buti on arrangement over the term of the agreement.

On November 17, 1998, the Court entered an order granting Sun’s request for a prel i minary i nj unction, hol di ng that Sun hadestabl i shed a l i kel i hood of success on i ts copyri ght i nfri ngement cl ai ms, because Mi crosoft’s use of Sun’s technol ogy i n i tsproducts was beyond the scope of the parti es’ l i cense agreement. The Court ordered Mi crosoft to make certai n changes i n i tsproducts that i ncl ude Sun’s Java technology and to make certai n changes i n i ts Java software devel opment tools. The Court alsoenj oi ned Microsoft from enteri ng i nto any l icensi ng agreements that were condi ti oned on exclusi ve use of Mi crosoft’s Java Vi rtualMachi ne. Mi crosoft appeal ed that rul i ng to the 9th Ci rcui t Court of Appeal s on December 16, 1998.

On August 23, 1999 the 9th Ci rcui t Court of Appeals vacated the November 1998 prel i mi nary i nj uncti on and remanded thecase to the Di stri ct Court for further proceedi ngs. Sun i mmedi atel y fi l ed two moti ons to rei nstate and expand the scope of theearl i er i nj unction on the basi s of copyri ght i nfri ngement and unfair competition. On January 25, 2000, the Court i ssued rul ings onthe two moti ons, denyi ng Sun’s moti on to rei nstate the prel iminary i njunction on the basi s of copyri ght i nfringement and granti ng,i n part, Sun’s moti on to rei nstate the prel iminary i nj unction based on unfair competition. Mi crosoft i s i n compl iance wi th the termsof the parti al ly rei nstated preli minary i njuncti on and wi l l not need to undertake any further acti on to compl y wi th the terms of thei nj uncti on. No other heari ng or tri al dates have been set.

The parti es have fi l ed mul ti ple summary j udgment motions on the i nterpretation of the Agreement and on Sun’s copyri ght andtrademark i nfri ngement cl ai ms. On February 25, 2000, the Court entered an order denyi ng both parti es’ moti ons for summaryj udgment as to whether the Agreement authori zes Mi crosoft to di stri bute i ndependently developed Java Technol ogy. On Apri l 5,2000, the Tri al Court entered an order denyi ng Sun’s moti on for summary j udgment regardi ng the i nterpretation of Section 2.7(a),whi ch sets forth certai n requi rements that Sun must meet when they del iver Java Technology to Mi crosoft. On May 9, 2000, theCourt entered an order granti ng Microsoft’s moti on to dismi ss Sun’s copyri ght i nfri ngement cl ai m and on May 25, 2000, the Courti ssued a tentati ve order granting Microsoft’s moti on to di smi ss Sun’s cl ai m that i t i senti tl ed to l i qui dated damages based on theal l eged i mproper posti ng of i ts source code by Mi crosoft. The Court has i ndi cated i ts i ntention to set a heari ng on the remai ni ngmoti ons i n September 2000.

On May 18, 1998, the Antitrust Di vi si on of the U.S. Department of Justi ce (DOJ) and a group of state Attorneys General fi l edtwo anti trust cases agai nst Mi crosoft i n the U.S. Di stri ct Court for the Di stri ct of Col umbia. The DOJ complai nt al leges vi ol ations ofSecti ons 1 and 2 of the Sherman Act. The DOJ complai nt seeks decl aratory rel ief as to the vi ol ati ons i t asserts and prel i mi naryand permanent i nj uncti ve rel i ef regardi ng: the i ncl usi on of Internet browsi ng software (or other software products) as part ofWi ndows; the terms of agreements regardi ng non-Mi crosoft Internet browsi ng software (or other software products); taki ng orthreateni ng “acti on adverse” i n consequence of a person’s fai l ure to l i cense or di stri bute Mi crosoft Internet browsi ng software (orother software product) or di stri buti ng competi ng products or cooperati ng wi th the government; and restri cti ons on the screens,boot-up sequence, or functions of Mi crosoft’s operati ng system products. The state Attorneys General al l ege l argel y the samecl ai ms and vari ous pendent state cl aims. The states seek decl aratory rel i ef and preliminary and permanent i njunctive rel ief si milarto that sought by the DOJ, together wi th statutory penal ti es under the state l aw cl aims. The foregoi ng descri ption i s qual ified i n i tsenti rety by reference to the full text of the complai nts and other papers on fi l e i n those acti ons, case numbers 98-1232 and 98-1233.

msf t

34

Notes to Financial Statementsconti nued

On May 22, 1998, Judge Jackson consol i dated the two actions. The j udge granted Microsoft’s moti on for summary j udgmentas to the states’ monopoly l everage cl aim and permitted the remaining cl ai ms to proceed to tri al. Tri al began on October 19,

i tsmonopoly i n the desktop-PC operating system market, and that Mi crosoft attempted to monopol ize the Internet browser market i nvi ol ati on of Section 2 of the Sherman Act. The Court al so hel d that Mi crosoft di d not vi ol ate Secti on 1 of the Sherman Act byenteri ng i nto a number of contracts chal lenged by the government. The Court establ i shed a schedul e for consi derati on of theremedy to be i mposed i n a fi nal j udgment. On Apri l 28, 2000, the pl ai nti ffs submi tted a j oi nt proposed remedy that i ncl udedaproposed break-up of Mi crosoft i nto two compani es, an operati ng systems company, and a company that woul d own al l ofMi crosoft’s other products and busi nesses. Mi crosoft submi tted i ts proposed remedy and i ts proposal for further remedyproceedi ngs on May 10, 2000. On June 7, 2000, Judge Jackson entered the government’s proposed order nearl y verbatim as hi sfi nal j udgment i n the case. That j udgment orders a di vesti ture that wi l l create two separate compani es, an “Operati ng SystemsBusi ness” and an “Appl i cations Busi ness,” to be i mpl emented one year fol lowing a fi nal decisi on on appeal. It al so provi des for abroad range of “conduct” remedi es that woul d have gone i nto effect i n 90 days, absent a stay. On June 13, 2000, Mi crosoftappeal ed to the Uni ted States Court of Appeals. The Court of Appeals i mmediately entered an order notifying the parti es that theCourt woul d hear al l matters rel ated to thi s appealen banc. The government then asked Judge Jackson to enter an ordercerti fyi ng the case for di rect appeal to the Supreme Court. On June 20, 2000, Judge Jackson certi fi ed the case for di rect appealto the Supreme Court and si mul taneousl y granted Mi crosoft’s request to stay the enti re remedy pendi ng fi nal appeal. Thecerti fi cation divests the Court of Appeals of j uri sdi cti on over the case unti l the Supreme Court deci des whether or not to acceptj uri sdi cti on of the case, whi ch i s enti rely di screti onary. The parties have agreed to a bri efing schedule on thi s i ssue, accordi ng towhi ch Mi crosoft fi l ed i ts Juri sdi cti onal Statement on July 26, 2000, the government responded on August 15, 2000, and Mi crosoftrepl i ed on August 22, 2000. If the Supreme Court declines to accept j uri sdi cti on, the appeal wi ll return to the Court of Appeal s. Ifthe Supreme Court accepts

Thi s standard i s based on a management approach, whi ch requi res segmentati on

based upon the Company’si nternal organization and discl osure of revenue and operating i ncome based upon i nternal accounting methods. The Company’sfi nanci al reporting systems present vari ous data for management to run the busi ness, i ncl uding i nternal profi t and l oss statements(P&Ls) prepared on a basi s not consi stent wi th general l y accepted accounti ng pri nci pl es. Reconci l i ng i tems i ncl ude certai nel ements of unearned revenue, the treatment of certai n channel i nventory amounts and esti mates, and the cl assi fi cati on ofrevenue from product support and consul ti ng. Addi ti onal l y, the i nternal P&Ls use accel erated methods of depreci ati on andamorti zation. In fi scal 2000, the Company’s i nternal P&Ls i ncl uded the Bl ack-Schol es val ue of empl oyee stock opti on grants,amorti zed over the remai ning months of the fi scal year of the grant, as wel l as mi nor changes to the segments’ composi tion due tovari ous i nternal reorganizations duri ng the year. Fi scal 1999 di scl osures have been restated for consi stent presentation. It i s notpracti cabl e to restate fi scal 1998 for these changes.

Long-l i ved assets total ed $1.5 bil lion and $1.8 bi llion i n the United States i n 1999 and 2000 and $154 mil lion and $126 mi l l i oni n other countri es i n 1999and 2000.

msf t

36

Quarterly Information

Unaudi ted (i n mi llions, except per share amounts)

Quart er Ended

Sept. 30

Dec. 31

Mar. 31

June 30

Year

1998

Revenue

$

3,334

$

3,792

$

3,984

$

4,152

$

15,262

Gross profi t

2,800

3,179

3,344

3,479

12,802

Net income

663

1,133

1,337

1,357

4,490

Basi c earni ngs per share

0.14

0.24

0.27

0.27

0.92

Di luted earni ngs per share

0.13

0.21

0.25

0.25

0.84

Common stock pri ce per share:

Hi gh

37.69

36.66

45.47

54.28

54.28

Low

30.82

29.50

31.10

40.94

29.50

1999

Revenue

$

4,193

$

5,195

$

4,595

$

5,764

$

19,747

Gross profi t

3,544

4,407

3,887

5,095

16,933

Net income

1,683

1,983

1,917

2,202

7,785

Basi c earni ngs per share

0.34

0.40

0.38

0.43

1.54

Di luted earni ngs per share

0.31

0.36

0.35

0.40

1.42

Common stock pri ce per share:

Hi gh

59.81

72.00

94.63

95.63

95.63

Low

47.25

43.88

68.00

75.50

43.88

2000

Revenue

$

5,384

$

6,112

$

5,656

$

5,804

$

22,956

Gross profi t

4,672

5,356

4,904

5,022

19,954

Net income

2,191

2,436

2,385

2,409

9,421

Basi c earni ngs per share

0.43

0.47

0.46

0.46

1.81

Di luted earni ngs per share

0.40

0.44

0.43

0.44

1.70

Common stock pri ce per share:

Hi gh

100.75

119.94

118.63

96.50

119.94

Low

81.63

84.38

88.13

60.38

60.38

The

Company’s common stock i s traded on The Nasdaq Stock Market under the symbol MSFT. On Jul y 31, 2000, there were107,824 regi stered hol ders of record of the Company’s common stock. The Company has not pai d cash di vidends on i ts commonstock.

msf t

37

Report of Management

Management i s responsi bl e for prepari ng the Company’s fi nanci al statements and the other i nformati on that appears i n thi sannual report. Management bel i eves that the fi nanci al statements fai rl y refl ect the form and substance of transacti ons and

The Company maintains a system of i nternal accounting pol i ci es, procedures, and control s i ntended to provi de reasonabl eassurance, at appropri ate cost, that transacti ons are executed i n accordance with Company authori zati on and are properl yrecorded and reported i n the fi nanci al statements, and that assets are adequatel y safeguarded.

To the Board of Di rectors and Stockhol ders of Mi crosoft Corporati on:

We have audi ted the accompanying consol i dated bal ance sheets of Mi crosoft Corporati on and subsi di ari es as of June 30,

1999 and 2000, and the rel ated consol idated statements of i ncome, cash fl ows, and stockhol ders’ equi ty for each of the threeyears i n the peri od ended June 30, 2000, appeari ng on page 11 and pages 19 through 36. These fi nancial statements are theresponsi bi l i ty of the Company’s management. Our responsi bi lity i s to express an opi ni on on these fi nancial statements basedon our audi ts.

Other i nformati on contai ned i n thi s document represents the current vi ew of Mi crosoft Corporati on on the i ssues di scussed as of the date of publ i cati on. Because Mi crosoft mustrespond to changi ng market condi ti ons, i t shoul d not be i nterpreted to be a commi tment on the part of Mi crosoft.